Short sales

Investors can potentially profit in different market conditions. Many investors earn returns when prices rise, but you can also try to profit when prices fall. Selling short (also called short selling) is a strategy that lets an investor bet against a security and potentially profit if its market value declines.

Selling short is more complex than going long (buying) a security. You must work with your broker-dealer to confirm the firm can locate and lend the security you want to short. The basic process looks like this:

• You borrow the security from the brokerage firm and agree to return it in the future.
• You sell the borrowed security in the market right away.

After the sale, you’re hoping the market price falls. At some point, you must buy the security back and return it to the broker-dealer. The lower the repurchase price, the higher the profit.

For example, an investor sells short a stock at $75 per share. A few weeks later, the stock falls to $60, and the investor repurchases it at $60. The investor earns a $15 per share profit ($75 sale price − $60 repurchase price).

Sometimes an analogy makes short selling easier to picture. Imagine you believe the price of a concert ticket will fall because demand is weak, and you want to profit from that drop. If a friend has a ticket, you could borrow it and promise to return it before the concert. After borrowing the ticket, you sell it online for $50.

If you’re right and demand stays low, tickets might be selling for $40 the day before the concert. You could buy a ticket for $40 and return it to your friend. Your profit is $10 ($50 − $40). Short selling works the same way.

Selling short also comes with significant risk and can lead to large losses if the market price rises. For example, suppose you sell short a stock (or a concert ticket) for $50 because you expect demand to fall. Instead, demand surges and the market price rises to $200. If you buy it back at $200 to return it, your loss is $150 per share (or per ticket).

A key risk is that there’s no upper limit on how high a market price can rise. As the price increases, the repurchase becomes more expensive and the potential loss grows.

Selling short securities is risky, but it can provide a way to potentially profit in a bear (falling) market. Because of the complexity and the possibility of large losses, only the most sophisticated (knowledgeable and wealthy) investors should consider selling short.